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Global Diversification Or Domestic Focus? A Look At HSBC Holdings plc And Lloyds Banking Group plc

Global and local banking business models each have their own advantages and their disadvantages. Global diversification can help a bank reduce its earnings volatility and take advantage of faster growing economies. With domestic focus, the bank builds scale in one key market, allowing it to become more cost efficient and increase customer profitability.

Before the financial crisis, almost every major bank pursued the global growth strategy, but things are very different now. Greater underlying profitability has enabled domestic banks to outperform globally diversified banks. Furthermore, the stock markets currently value domestic banks at much higher multiples on book value.

Spread too thinly

Lloyds‘ (LSE: LLOY) shares are valued at a 27% premium to  its book value, but the bank is still attractive on an earnings basis — its forward P/E ratio is just 10.6. This compares to HSBC‘s (LSE: HSBA) 4% discount to book value and a forward P/E of 11.4.

HSBC’s underperformance is the result of the bank spreading capital too thinly across too many markets. With 22 key markets, HSBC does not have enough local scale needed to keep costs low in many markets. The bank should rethink its “the world’s local bank” slogan.

Complexity

Complexity is another problem, causing HSBC to spend as much as $1 billion more annually on regulatory and compliance costs than it did before the financial crisis. Its cost to income ratio was 67.3% in 2014, compared to Lloyds’ 51%. Regulators also demand systemically important banks to hold more capital.

Lloyds, being less complex, can hold less capital. This raises the bank’s leverage, allowing it to generate a higher return on equity. Some analysts would argue that this makes Lloyds inherently more risky, but its simplicity is its counterbalance.

Higher leverage is not the only reason for Lloyds’ stronger returns on equity; it is also the result of its huge local scale and the profitability of retail and commercial banking in the UK market. The average return on equity for retail and commercial banking in the UK is usually in the mid-teens, after PPI redress provisions and other fines are excluded.

The recovering UK economy is also more attractive, relative to slowing emerging markets. Benefiting from the improving economy, Lloyds is seeing its loan loss provisions fall, which has a direct impact to the bank’s bottom line.

Too little, too late

Strict regulations and limits on foreign ownership has made it difficult for foreign banks to build sufficient scale in emerging markets. A market share of at least 10% is generally regarded as the minimum needed to be sufficiently cost efficient for retail banking. HSBC falls short of this 10% threshold in many markets. 

HSBC’s management appears to recognise this, by looking to sell its Brazilian retail bank. Although a sale of its Brazilian unit may provide a short-term boost to its share price; in the longer term, it is too little, too late. To become more competitive, HSBC needs to exit many more markets.

Outperform

Lloyds, which is already on the mend, faces less execution risks. It will soon return to regular dividend payments and its return on equity (ROE) is getting closer to its 13.5-15% target. In contrast,  HSBC has lowered its ROE target from 12-15% to “more than 10%”.

With emerging market economies slowing, even meeting that 10% ROE target could be difficult. The contrasting outlooks between the two banks should help Lloyds to continue to outperform HSBC in the medium term.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.